Context:
The 16th Finance Commission (2026–31), chaired by Dr. Arvind Panagariya, recommended maintaining the States’ share in central tax devolution at 41%, while introducing States’ GDP contribution as a new criterion in horizontal devolution.
Key Highlights:
- Constitutional Framework of Fiscal Federalism
- Article 280: Provides for the establishment of a Finance Commission every five years to recommend distribution of tax revenues.
- Article 270: Specifies the distribution of net tax proceeds between the Union and the States.
- Vertical Devolution Recommendation
- The 16th Finance Commission retained the States’ share at 41% of the divisible pool.
- This maintains the formula set by the 15th Finance Commission (2020–2026).
- The reduction from 42% (14th FC) to 41% occurred after the reorganization of Jammu & Kashmir into two Union Territories.
- Horizontal Devolution Changes
- The Commission introduced States’ contribution to GDP as a new criterion.
- The aim is to recognize economic efficiency and encourage growth-oriented policies.
- Divisible Pool Composition
- The divisible pool excludes cess and surcharge, which remain with the Centre.
- For 2025–26, the divisible pool is estimated to account for around 81% of the Centre’s gross tax revenue.
- States’ Demands
- States had demanded:
- Increase in vertical devolution to 50%.
- Inclusion of cess and surcharge in the divisible pool.
- Cap on cess and surcharge collections by the Centre.
- Finance Commission’s Position
- The Commission concluded that including cess and surcharge in the divisible pool or capping them is not constitutionally permissible under the current framework.
- However, it recommended that the Centre gradually reduce reliance on cess and surcharge.
- Impact on States
- The revised formula results in a slight increase in the share of southern and western States.
- The share of large northern and central States has marginally declined, reflecting recognition of economic efficiency and contributions to national growth.
Relevant Prelims Points:
- Finance Commission:
- Constitutional body under Article 280.
- Recommends distribution of tax revenues between the Union and the States.
- Vertical Devolution:
- Distribution of tax revenue between the Centre and States.
- Horizontal Devolution:
- Distribution of funds among States based on criteria like population, income distance, area, and now GDP contribution.
- Divisible Pool:
- Net tax revenues of the Centre shared with States, excluding cess and surcharge.
- Cess and Surcharge:
- Taxes imposed by the Union government for specific purposes, not shared with States.
Relevant Mains Points:
- Importance of Fiscal Federalism in India
- Fiscal federalism ensures equitable distribution of resources among levels of government.
- It addresses regional disparities while maintaining national unity.
- Debate Over Cess and Surcharge
- Increasing reliance on cess and surcharge reduces the effective share of States in central revenues.
- States argue this undermines cooperative federalism.
- Balancing Equity and Efficiency in Devolution
- Traditional criteria emphasized population and income distance, focusing on redistribution.
- Including GDP contribution encourages growth-oriented fiscal behavior.
- Challenges in Centre–State Fiscal Relations
- Rising expenditure needs for infrastructure, defense, and welfare programs create pressure on Union finances.
- States face fiscal stress due to subsidies, power sector losses, and rising debt.
- Way Forward
- Reduce reliance on cess and surcharge to strengthen fiscal federalism.
- Improve efficiency of state subsidies and fiscal discipline.
- Encourage power sector reforms and sustainable debt management.
UPSC Relevance:
• GS Paper 2 – Polity: Finance Commission and Centre–State relations.
• GS Paper 3 – Economy: Fiscal federalism and tax devolution.